Marketing Feature: Personal services business: Once a fairytale, now a horror story

Personal services business: Once a fairytale, now a horror story

Once upon a time, employees could incorporate themselves and continue to provide services to former employers. Business was conducted as a corporation – a Personal services business (PSB) – and the individual providing the service was not considered an employee of the entity paying for the service.

For incorporated employees this was beneficial in many ways: they were eligible for the low corporate tax rate, they could deduct most expenses incurred for the purposes of earning income and they could use dividends to split income with their family members. Employers also liked this arrangement because instead of an employee, they were paying a corporation for services and no longer had to do deductions at source.

Too good to be true? The answer seems to be yes.

In 1981, the fairy tale shine faded when the federal government introduced PSB rules that impacted incorporated employees. PSBs were no longer eligible for the small business deduction and were no longer eligible for the low corporate tax rate. Also, the ability of PSBs to reduce taxable income by deducting expenses was limited to the same kinds of expenses that salaried employees could deduct to offset employment.

The absence of deductions, combined with a high corporate tax rate, personal taxes on dividends, and the cost and complication of corporate compliance, resulted in a tax burden that was as high or higher than that of salaried employees. This essentially killed the goose that laid the golden egg…for a while.

Slowly, things began to change. First, came the concept of the general rate income pool and eligible dividends. This allowed income earned in a company that was subject to the high corporate tax rate, to pay dividends to the shareholder(s) at a preferential personal tax rate such that the total tax paid by the PSB and the shareholder approximated taxes payable by a salaried employee.

While that by itself may not have encouraged anyone to establish a PSB, as corporate tax rates began to drop significant tax deferral opportunities presented themselves. All this seemed to be developing under the radar of the Canada Revenue Agency…until recently.

Fast forward to October 31 2011, when the Minister of Finance announced draft legislation to increase the PSB tax rate to about 13% higher than the general corporate rate. Corporate taxes payable by the PSB alone will approach the tax that would have been paid by the incorporated employee if that individual had simply earned the income as an employee.

And say goodbye to tax deferral opportunities. When you factor in the additional tax that must be paid when income is distributed as dividends, in almost all cases, operating through a PSB will mean that the total tax paid by the PSB and the shareholder on receipt of dividends will be significantly greater than if the incorporated employee had earned the money directly as an employee.

The new legislation will leave many taxpayers scrambling to determine their options and the best structure to help them to minimize their taxes. If you are in a PSB, you should discuss your circumstances with a tax advisor. You may want to stop earning your PSB income through your corporation and start earning your income as a salaried employee.

Sadly, there does not appear to be a “happily ever after” for PSBs at this time.